Stock Trends, Trendlines, and Trendline Penetrations

By Dr. Winton Felt

One of the principle concepts that Charles Dow identified in his Dow Theory is that security prices do trend, and those trends can be defined by the use of trendlines.  To construct a trendline when the stock is rising, you would connect two or more low points in the stock's chart pattern.  The line would then be extended to the right and used to estimate where support (buying pressure) is likely to be the next time the stock declines.  When the stock is declining, you would draw the trendline by connecting two or more high points in the stock's chart pattern.  The line would then be extended to the right and used to estimate where resistance (selling pressure) is likely to be the next time the stock rises.  The idea is that once an upward trending stock has declined two or more times to low points positioned on a rising trendline and subsequently rebounded, the trendline will continue to function as support until it is penetrated.  If a downward trending stock has risen two or more times to high points positioned on a declining trendline and subsequently pulled back, the trendline will continue to function as resistance until it is penetrated.

Trendlines are very helpful tools for making unemotional decisions based on stock behavior rather than on the trader's hunches or feelings.  For example, if a rising stock has a rising trendline that is at $50, then a close of the stock below $48.50 can reasonably be interpreted as an objective sell signal based on analytical evidence generated by the stock's behavior.

This raises another question.  What constitutes a valid breaking of a trendline?  Some traders consider the trendline broken if the stock closes below the trendline.  Robert D. Edwards and John Magee in their book, Technical Analysis of Stock Trends suggest that a 3% penetration of the trendline by the closing price is a sensible way to define a trend penetration.  This would be a good approach if a person were using a "mental" stop loss.  However, if a stop loss has been entered with a broker and is therefore likely to be triggered during market hours, then Edwards and Magee suggest that a 6% penetration by the stock's low price is reasonable.  The greater distance in the latter case would help reduce the probability of the stop loss being triggered by a meaningless intra-day price spike.  Another approach is to use a time filter.  Traders who use this approach require that the stock's closing price be below the trendline for two consecutive days.  A one-day close below the line would not count.  These rules are applied to major trendlines and also to important support and resistance levels.

Traders at http://www.stockdisciplines.com consider volume patterns to be quite helpful in evaluating the importance and meaning of a trendline penetration.  For example, suppose that a stock in a rising trend has a series of peaks with progressively lower volume.  The volume on those upward moves should remain relatively high because those moves are in the same direction as the prevailing trend.  If volume is progressively decreasing instead, it would suggest that the underlying strength of that trend is decreasing.  Therefore, a downward penetration of the rising trendline when the upward moves have been accompanied by decreasing volume would be considered to be especially significant.  Also, a surge in volume during a downward penetration of a rising trendline is particularly significant because previously volume surges were supporting price moves to the upside.  Therefore a volume surge on a penetration to the downside suggests a definite change in the relationship between supply and demand.  Before, demand was in control as volume surged while prices rose (buyers were piling on their orders).  Now, supply is overwhelming demand as volume surges while prices fall (sellers are piling on their orders).